Judge Rejects Free Speech Shield for Credit Raters

A federal judge in New York has rebuffed efforts by two credit rating agencies to seek constitutional free speech protection for their evaluations of securities instruments.

U.S. District Judge Shira Scheindlin of the U.S. District Court for the Southern District of New York issued a ruling rejecting the free speech argument in a suit involving ratings on the Cheyne Structured Investment Vehicle, a package of debt that included subprime mortgages, according to a Reuters report. The Cheyne SIV fund went bankrupt in August 2007.

In her 68-page ruling, Scheindlin said rating agencies are not given the broadest free-speech protection for distributing ratings to “a select group of investors” rather than the public at large. A rating company’s judgment about a security can be challenged “if the speaker does not genuinely and reasonably believe it or if it is without basis in fact.”

Cheyne issued some notes with “triple-A” ratings, the same as the U.S. government, and others that won “the highest credit ratings ever given to capital notes.” Scheindlin said the rating agencies were paid more than three times their normal rate and their fees were “contingent upon the receipt of desired ratings.”

Defendants in the case include Moody’s Investors Service and Standard & Poor’s Corp, which issued ratings on the notes, and Morgan Stanley, which marketed them. They are accused of fraud for making misstatements about the Cheyne debt. The case was brought by Abu Dhabi Commercial Bank and King County in Washington state.

One beneficiary of the decision may be the California Public Employees’ Retirement System (CalPERS), which in July sued Moody’s, S&P and Fimalac S.A.’s Fitch Ratings for $1 billion over ratings on Cheyne and other securities (see “CalPERS Says Losses Caused by Inaccurate Credit Ratings”).

The case is Abu Dhabi Commercial Bank vs. Morgan Stanley, U.S. District Court, Southern District of New York (Manhattan), No. 08-7508.